How Do I Read My Income Statement as a Business Owner? – Part III

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Using Vertical and Horizontal Analysis To Find Where To Improve Your Business and Compare Performance Against Other Businesses

Vertical and Horizontal Analysis

This is our third video on how to read your income statement as a business owner.  We’ve gone through what the P&L is and how it’s used, and what the structures of it are.  Now we’re going to talk about how to analyze it.  There are generally two ways that you can analyze an income statement: vertical analysis and horizontal analysis.

What Is Vertical Analysis?

Vertical analysis is where we look at every line in the P&L going from the top down by period – so vertical. We compare each number of each line/account to a base number, so that they’re all at a common size or ratio.  Usually we’re going to use revenue as our base number so we’re going to divide every other number in our income statement by revenue.  COGS, Gross Profit, Net Operating Income and all the lines in between will be divided by revenue.  By doing that, we’re going to see what every single one of those lines is as a percent of revenue which will give us a better understanding of how each dollar of revenue is being spent in the business and allow us to follow the money as it flows through from revenue to the bottom line.

The benefit of vertical analysis is that we get to see what the comparable sizes are of the different costs, expenses, and profitability.  We’ll be able to say things like, “30% COGS is a little high for our industry, why aren’t we more efficient there?”, or “People costs are 50% of our revenue, maybe that’s a little bit too much and we need to trim that down.”

What Is Horizontal Analysis?

Horizontal analysis is where you look across your Income Statement at different periods.  In this case we’re going to look at different months with a horizontal analysis.  This sort of analysis is also often called a time series analysis. In this example, we’re going to be comparing months against each other. We’re going to use percentages while also looking at actual dollar amounts.  We’re also going to track how much they change as a percent of revenue each month.  Horizontal Analysis helps with seeing patterns and trends over time.  Any kind of time series is going to allow you to see how things change in different slices of time. This sort of analysis will help us understand that if the different parts of the business are getting better or worse.

Overall, we’ve got vertical analysis which is going to let us see how the dollars flow through the business. This tells us whether we’re overweight or underweight on certain costs, expenses, and certain margins.  Then we’ve got horizontal analysis which will tell us how each one of those things are performing over time in a trend.

Looking at the example P&L, you’ll notice that we’ve added a couple more lines.  What we’ve added are percentages between every line in the Income Statement that are equal to the line above them divided by total revenue for that month.

Looking at January of 2020 to do our vertical analysis, we saw that 63% of our revenue was generated from projects and 38% of our revenue was generated from monthly services.  There was zero other income and that got us our income of $80,000.  Looking at our COGS, if we look at our contractor COGS in the month of January, our contractor COGS were 8% of revenue, and our employee COGS were 58% of revenue. When you take those two things, you get the total cost of goods sold. When you subtract that from revenue, we get our gross profit.  Our total cost of goods sold in January were 65% and our total gross profit was 35%.

How To Interpret These Percentages?

The way we interpret a gross profit of 35% is, “of every dollar of revenue that was brought in in January, 65 cents went to earning and fulfilling on that revenue and 35 cents were left over to cover expenses and pay owners.”  We paid our contractors and our billable employees for billable work in this example.

Let’s look at our operating expenses. We see 16% of revenue went to people cost, 4% of revenue went to occupancy 5% of revenue went to sales and marketing, 1% of sales went to professional services and nothing went to other expenses. We also see that total expenses ended up being about 26% of revenue. If we know we only have 35 cents left at the gross profit line and we’ve spent 26 cents on total expenses, then the difference should be our net operating income. In this case, 9%.

We then look at other income and other expenses and we didn’t have any other income so at zero percent. If we look at other expenses we did have $300 and other expenses. As you can see, that’s pretty nominal as a percent of total sales. So we basically ended up with about 9% of net income. Again, we translate this as, “for every dollar of revenue that came into the business in January, nine cents ended up being in our bottom line/net income before tax. That’s how you do a vertical analysis.

Using horizontal analysis, we look at individual accounts and their performance over time, across periods. If you look at January, we can see that project revenue in January was 63% of total revenue. In February, it was only 22%. In March, it was 23%, in April 17%, in May 63%, in June 39%. In total, it ended up being about 39% of revenue.  From this, we see some variability.

Using Quarters To Better Understand Monthly Trends

If you highlight three months at a time, corresponding to the quarters of the year, at the bottom of your Excel, you’ll actually see some averages and counts and sums done for you. If we look at our average in Q1, project revenue was 36% of revenue, Q2 was 38%, and Q3 was 34%.   We can see that project revenue is slowly becoming less and less of the total revenue in the quarterly trend. Then we can look at monthly service revenue the same way, and see what percent of revenue it made up.  Monthly services revenue was 64% in Q1, 63% in Q2, and 63% in Q4.   Overall, we’ve now learned that the business is about 60/40 monthly services revenue to project revenue as a revenue mix.

The power of these two different analyses come from combining them. So, before we jump into combining them,

Let’s look at cost of goods sold. We look at contractors and employees over time as a percent of revenue.  We see in Q1 that contractors made up about 8%, 19% in Q2, and 17% in Q3.  It appears that contractor costs have jumped up from 8% to the 19% range. That gives me a question about how we’re structuring our service business. Are we relying too much on contractors or is that a move that we’ve made to create a more variable workforce that’s a little bit more nimble in case work dries up? This depends on the strategy of the business owner.

Now let’s look at our employees who are billable and therefore are in COGS.  They are about 60% of revenue in Q1, 49% in Q2, and about 40% in Q3.  We are seeing that as our cost of contractors goes up, we aren’t having to hire as many people.  We’re seeing that our employee costs are coming down as a percent of revenue. The question we have to ask ourselves is, “Long term, does that make sense as a strategy?”

By adding all our COGS up, we can see total cost of goods sold. We see that in Q1, Cost of Goods Sold average at about 70 cents of every dollar, Q2 was about 68 cents of every dollar, and 57 cents of every dollar in Q3. This could be great news. Somehow our strategy is working because we’re keeping more and more percent of revenue over time. These are healthier and healthier gross profit margins over time so that’s really nice to see. That’s the power of horizontal analysis.

The Power of Combining Horizontal and Vertical Analysis on Your Income Statement

Combining horizontal and vertical analysis is where the power really comes out because now we can say, “We know what our product mixes are, we know that our gross profit margin is getting healthier over time. Now let’s see where else we can make improvements in the business.” For example, we see our people costs are at about 22% of revenue.  Is that absolutely essential for this business?  Is it necessary to cut down expenses to drive more money to the bottom line to achieve our profit goals? Will that stifle growth and prevent us from some of our more long term growth strategies.

That’s where you got to really dig in, but at least this gives you an idea of where the money is going so that you can start to think critically about how you’re going to achieve your goals. For example, we can see sales and marketing was 4-5% of revenue for the first couple months, but then all of a sudden our sales and marketing budget dwindled.  Is that part of a strategy or is that something where we just let the gas off?  Is that going to prevent us from hitting our growth goals next year? 

By slicing the Income Statement up, we get a better idea of where we need to look so that we can implement strategy. This is how you use horizontal analysis and vertical analysis within one business.

Using Horizontal and Vertical Analysis To Compare Separate Companies

Remember a couple videos back when we said, “When anyone tells you that their business is efficient, your first question always should be, ‘Compared to what?’” We gone ahead and made two Income Statements for two similar companies. The second one is called “Chris’s More Profitable But More Volatile Service Business.”  Now we get to compare two businesses using horizontal and vertical analysis.

We are going to use the same chart of accounts to keep it really simple.  We start off by looking at the totals of income for each business. Chris’s profitable service business did $622,000 in total income in the first three quarters with again 40% of that being project revenue and 60% of that being monthly services revenue.  I’m thinking monthly service revenue seems to be like a more repeatable style of business and it’s a little bit more stable so you can count on it more. It’s also easier to forecast so I’m liking that mix. Then I look at the more volatile business and see that this business has done less in income, closer to $450k and more of its work is in Project revenue. So it’s a more volatile business. I’m going to start to look at the horizontal analysis and see that the revenue of the more volatile business is truly fluctuating more.  However, the volatile business has achieved higher single month revenues, so maybe this company has a higher potential and  is better at landing bigger clients or better work.

Looking at COGS for both businesses, the more stable and bigger business had COGS of 62% of revenue.  The more volatile and profitable business had gross profit that was higher as a percent of revenue because cost of goods as a percentage was lower. Now we’ve got an interesting situation here where we’ve got a more volatile but more profitable business.  Now we got to figure out what strategy to do for each business.

We’ve left all operating expenses the same for these two businesses just for the sake of focusing on the cost structure up in COGS.  Because both of these businesses have similar operating expenses and similar other income and other expenses, the gross profit reflects almost directly into the net income. What we see here is that we end up with a net income of seven 7% in Chris’s Business, which means seven cents of every dollar of revenue ends up in the bottom line for this business.

The more volatile but more profitable business had Net Income of 17%, or 17 cents of every dollar ends up in the bottom line. We ended up only generating $44,000 in net income in the in the business that had a higher revenue, but we generated $93,000 in net income in the more volatile, but more profitable business.

The question you have to answer as an investor or business owner is, “Which one would you buy, and how, if you own this business, do you use horizontal and vertical analysis to get an idea of where you need to invest your time and attention and resources to help the business become more stable, to grow faster, and/or to become more profitable?”

And this is why finance is so fun. So thanks for watching

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Andrew Escher

Andrew Escher

We are passionate about helping business owners feel confident so they can enjoy the journey of entrepreneurship and create value for themselves and their communities. Understanding the steps required to scale a business helps empower business owners. That’s why I work in finance now. We are here to help in any way we can. Check out one of our workshops where we can help each other down the path. Or schedule a call with us!

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